Friday, April 24, 2015

Expected Real Dollar Spending Budget Shaping

As indicated in previous posts, retirees and their financial advisors can use the Actuarial Approach to provide different patterns of future expected real dollar spending budgets.  If the user of the "Excluding Social Security" spreadsheet on this website inputs the recommended assumptions and sets the desired increase in payments equal to the inflation assumption, annual future budgets (including Social Security) are expected to remain constant in real dollar terms from year to year until the retiree reaches almost age 90  (when age plus life expectancy starts to exceed 95) if all assumptions are realized, assumptions are not changed and actual spending exactly equals budgeted spending.  As discussed in our previous post,  unlike under many other withdrawal strategies, this is true under the Actuarial Approach even if the retiree has other fixed dollar sources of retirement income such as pension income or immediate or deferred annuity income. 

There is a school of thought that says that spending generally declines in real terms as we age.  See our post of July 19, 2014 for a discussion of David Blanchett's research on this subject.  In that post we indicated that developing a declining real dollar budget (on an expected basis) can be accomplished using the Actuarial Approach by inputting a smaller percentage for desired increases in payments than the expected annual inflation assumption.   In addition, the figures in the tab labeled "Inflation-Adjusted Runout" will show the expected future budgets if such an approach is used.  Note that these declining spending budget components are not coordinated with the Social Security component of the budget (which is inflation-indexed under current law), so the retiree/financial advisor would have to make appropriate adjustments if the retiree's total spending budget is desired to be declining from year to year at a desired rate. 

A couple of days ago, I received a request from a reader named Greg asking if there were some way to modify the Excluding Social Security spreadsheet so that his expected spending could remain constant in real dollar terms for the first 10 years of his retirement and then decline in real terms by 1% per year thereafter.  While the spreadsheet cannot perform this task as easily as it can for a constant percentage decrease, with some extra calculations, it can accomplish this objective on an approximate basis.  Since Greg didn't tell me his age or financial situation, I am going to make up some numbers for him for purposes of illustrating how one can go about solving this problem. 

I am going to use the current recommended assumptions of 4.5% investment return, 2.5% inflation and an expected payment period of 95-age or life expectancy if greater.  I'm going to assume that Greg is age 65 with $500,000 of accumulated savings, no fixed dollar pension or annuity benefits and no bequest motive.  For the first 10 years of his retirement, Greg is going to have to calculate an average desired rate of payment increase.  In the first year, this will be equal to 10 X 2.5% (the inflation assumption) plus 20 X 1.5% (the inflation assumption minus 1%), the result divided by 30 (or 1.83%).  He uses this percentage to determine the actuarial value in the spreadsheet and his first year spending budget.  In the second year, this average desired rate of payment increase will be 9 X 2.5% plus 20 X 1.5%, the result divided by 29 (or 1.81%).  After 10 years, he will just use 1.5% (assumed inflation minus 1%).  In determining his spending budget for years 2-10 (Excluding Social Security), he will increase his prior year budget by 2.5% and compare that result with the 10% corridor around the actuarial value he determined as described above.  For years, 11 through 30, he will increase his prior year budget by 1.5% and compare that result with the 10% corridor around the actuarial value he determines in those years.   

The graph below shows the shapes of the expected real dollar future budgets for Greg under 1) the constant real dollar approach, 2) the constant inflation minus 1% approach and 3) the hybrid approach Greg wanted (constant for 10 years and inflation minus 1% thereafter).  The graph assumes future experience exactly follows the recommended assumptions (4.5% investment return, 2.5% inflation, no changes in current assumptions and exactly the budget amount is spent each year).  While these assumptions for future experience will certainly not occur, the purpose of this exercise is to illustrate how the Actuarial Approach can be used to shape expected future budgets (excluding Social Security).  

(click to enlarge)

As I have said in many of my prior posts, you can spend your assets now or you (or your heirs) can spend them later.  If you want to "front-load" your spending, you can do this in several ways.  You can either decide to spend more than your constant real dollar budget in your younger years or you can develop a budget that you expect to decline in real dollar terms at some point during your retirement.  The bottom line is that this decision to front load should be a conscious one and not the result of using a particular withdrawal strategy that either starts out with too high of a withdrawal rate or, as discussed in my previous post, doesn't properly coordinate with fixed dollar pension/annuity income.  You should also have a sense of what the out-year implications may be of a decision to front-load your spending.  I believe the Excluding Social Security spreadsheet (and its inflation-adjusted Runout tab) does a good job of giving you the information you need in this regard.  If you aren't using the Actuarial Approach and you/your financial advisor aren't  adequately addressing these issues, you may wish to consider switching to the Actuarial Approach.  At a minimum, you may wish to compare the spending budget produced under your current approach with the budget produced under the Actuarial Approach and reconcile any significant disparities.